Demonetization Drive: Biggest Economic Reform by the MODI Government

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1 Demonetization Drive: Biggest Economic Reform by the MODI Government The historic demonetization move by the government is seen as a war on parallel economy, corruption, money laundering and to stop financing aid enjoyed by the terrorists. We expect this to have a direct impact on parallel economy and cash transactions. Along with the introduction of GST (expected by April 2017) this constitutes a far reaching reset of the Indian economy. The size of high denomination notes: As on Mar-16, Rs 500 and Rs 1000 notes accounted for 85.2% of total notes which is nearly Rs. 15 trn worth currency in the economy. As such, potentially a maximum of Rs 15 trn worth currency could be deposited into banks until Mar-17. Estimating the size of parallel economy : Conservatively assuming current parallel economy to be 25% of India s GDP (World Bank estimated parallel economy to be 23.7% of India s GDP in 2007), we estimate that the total size of unaccounted economy in cash would be around Rs trn. Impact on Markets: We believe government s move to demonetize higher denomination currency would have a far-reaching impact on Indian economy. It might have short-term pain but sure long-term gains. Apart from flushing liquidity in the banking system, demonetization could create short-term disruption in consumption and lead to behavioural changes in household s saving and consumption demand. We expect the following macro-economic impact may play out. Improvement in Government s fiscal position going forward: The implication for the fiscal deficit is a clear positive, as the government could gain windfall assuming large number of unaccounted currency does not make its way back into the banking system. Also incrementally we might see tax reporting discipline and hence the increase in tax collection through better reporting and audit. Higher benefits for the Government if lesser currency notes comes back into the system - The high denomination currency which has to be demonetized accounts for 85.2% of total notes which is nearly Rs. 15 trn worth currency in the economy. Conservatively, we assume that 80% of this old currency (Rs. 12 trn) will be deposited back in banks in order to get the new currencies in exchange. RBI will have to replace this Rs. 12 trn old currency with new currencies, which will be part of RBI s liability. The balance amount (unaccounted part of the demonetized currency) to the tune of Rs. 3 trn will not be deposited back in the banks will reduce RBI s liability to that extent as these notes may cease to exist. This windfall could arguably be a net gain for the government. It can have far reaching positive implications on the fiscal deficit next year. At the very least, this will lead to added flexibility for the government on fiscal and market borrowing, while allowing it to pursue accelerated infrastructure and banking sector related spending. Increase in Tax Reporting leading to better revenue hence better fiscal Going forward an increase in tax collection through better reporting and audit is likely. Once cash holdings are deposited into the banks to exchange new currencies, understating true income for tax purposes will be very difficult. This may potentially lead to better compliance, thereby increasing the tax base and revenues of the government.

2 System Liquidity to increase going forward: Banking system liquidity will get a major boost with deposits increasing and currency in circulation growth reducing going forward, as unaccounted cash money is flushed out of the system and future cash transactions also reduce. Despite an expected improvement in banking sector liquidity, we do not expect credit growth to improve meaningfully going forward. In fact credit growth could slow down in the short term as loans to the retail sector, NBFCs and services slow down further due to the adverse impact of demonetization in these segments. We expect banks to continue investing in government securities as part of their mandatory SLR requirements as well as an improved inflation and fiscal outlook will likely provide them with a greater opportunity in GSecs. The additional SLR demand over the next 6 to 12 months could be in vicinity of Rs 1 trn, purely on account of this move. Inflation expected to fall further: The move is likely to have a strong disinflationary impulse. The real estate sector, where a sizable proportion of transactions were conducted in cash (and often with black money), will be the worst affected followed by an expected slowdown in consumption demand. In our CPI forecast, we have assumed in housing inflation as well as slowdown in consumption demand, which has the potential to reduce CPI inflation average to 4.3% - 4.6%, from our current forecast of 4.8%. Growth to be positively impacted over medium to long term with near term hiccups: The move is likely to be negative for growth in the near-term, as informal sector activity, which is supported primarily through cash transactions, slows down in a knee-jerk response. By expenditure, personal consumption accounts for nearly 60% of total GDP. Sectors such as agriculture, construction, trade, hotels, transport, real estate and other services amount to around 56% of total GVA. Our assumption is close to 30% of the economy (50% of the above sectors) will be affected due to limited availability of legal tender. However this impact should be felt only in the short run as money from informal channels getting converted into formal banking channels because of the current measure would lead to faster expansion of our GDP ( due to higher multiplier than parallel economy),thereby leading to higher GDP growth going forward. Market View: Even as the world bond markets are shocked with the surprise election outcome in US, India bond markets are enjoying the latest move of our Prime Minister Modi. We have been constructive on Indian bonds for a while now with the view that monetary easing cycle will continue and better liquidity in the banking system will push bond yields lower. With the Government s latest announcement of de-monetizing higher denomination notes our view further got strengthened and we would like to re-iterate our positive view on Indian bonds. We continue to remain constructive on Indian rates as from a bond market perspective, immediate improvement in bank deposit base would lead to higher SLR demand. Further the fiscal impact will also be positive to the extent that there might be windfall gains from RBI which will help achieve deficit targets and could conceivably leave government balances on stronger footing. Also on the longer term, the move towards non cash economy and the introduction of GST should lead to structural improvement in tax compliance and tax/gdp ratio implying rerating of

3 India s fiscal position. Further with the expectations of disinflationary trend & anticipation of monetary easing would support bond yields. We expect further easing in terms of bps of rate cuts in the near future. Macroeconomic factors such as lower inflation and better fiscal will aid bond markets. On the other side, it is likely that the RBI will have to defer open market operation purchases to infuse liquidity into the banking system. That said, we believe rate cuts, better liquidity, better medium-term fiscal and disinflationary impulse should outweigh the lack of OMO purchases. Fund Recommendations: Duration Funds: In light of the above facts and expectations investors may consider long duration funds (Reliance Dynamic Bond Fund, Reliance Income Fund & Reliance Gilt Securities Fund) as these funds would benefit on further easing of yields over next 12 to 18 months. Reliance Dynamic Bond Fund aims at generating returns even in stable interest rate markets by exploring different trading strategies. The strategy to differentiate Tactical Positions from CORE Positions has paid off and we continue to re-iterate that it seems to be the right strategy going ahead in the current market scenario. Hence we feel that investors with months investment horizon can look at either of the above three duration funds however investors with the preference for active duration management fund along with an investment horizon of 3 years and above can consider investing in Reliance Dynamic Bond fund. Credit Funds: We also strongly feel that investors can consider our credit funds - Reliance Corporate Bond Fund and Reliance Regular Savings Fund- Debt from a constant debt allocation perspective due to their potential of delivering returns across all times. In expectations of improving liquidity conditions and money shifting from informal segment to formal banking system, we feel, such a scenario will create demand for investment products such as credit funds especially from accrual perspective. Over next 3 years or more a combination of moderate duration along with healthy accruals can help investors yield better returns. PRODUCT LABEL- Reliance Dynamic Bond Fund Income over long term. Investment in debt and money market instruments PRODUCT LABEL- Reliance Gilt Securities Fund

4 Income over long term Investment in Government Securities PRODUCT LABEL Reliance Income Fund Income over long term Investment in debt and money market instruments PRODUCT LABEL Reliance Regular Savings Fund Debt Option Income over medium term Investment predominantly in debt instruments having maturity of more than 1 year and money market instruments PRODUCT LABEL- Reliance Corporate Bond Fund Income over medium term Investment predominantly in corporate bonds of various maturities and across ratings that would include all debt securities issued by entities such as Banks, Public Sector undertakings, Municipal Corporations, bodies corporate, companies, etc Common Source: Bloomberg, RMF Internal Research, RBI Disclaimer: RNLAM is not guaranteeing/offering/communicating any indicative yields or guaranteed returns on investments made in the scheme. The information herein below is meant only for general reading purposes and the views being expressed only constitute opinions and therefore cannot be considered as guidelines, recommendations or as a professional guide for the readers. Certain factual and statistical

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